Wednesday, June 22, 2011

Spread update

With all the concerns about the U.S. economy being in a soft patch (and possibly entering a double-dip recession), and Europe being plagued by imminent PIGS defaults, credit spreads have understandably widened of late. But as the chart above shows, this widening has been rather tame when viewed from an historical perspective. Furthermore, the widening of spreads has occurred mainly as a result of declining Treasury yields; yields on high-yield debt haven't fallen as much as Treasury yields have. (The widely-followed HYG ETF is down only about 3% from its recent highs.) I note, moreover, that spreads remain quite elevated relative to their lows since 1997. Investment grade spreads today are almost as wide as they were during the 2001 recession, and high-yield spreads are more than twice as high today as they were in mid-2007.

The best explanation for why spreads have only widened marginally, despite the long list of concerns which currently weigh on the market, is that the market has been priced to a lot of bad news for some time now. Put another way, valuations in the corporate debt market have been and continue to be depressed.


Bill said...


Is it really clear how exposed US and European banks are to a Greek or other PIIGS defaults? Whose to know how big the credit default swap obligations are in the event of default?

Scott Grannis said...

The risk of credit default swaps, as well as derivatives in general, are often misunderstood and exaggerated by the press and the general public. Credit defaults (and all derivatives, for that matter) require two parties: a buyer and a seller. For every winner there is a loser, and vice versa. Additionally, over the counter derivatives such as CDS almost always have elaborate mechanisms to ensure against the possibility that one party in the transaction defaults on his obligations to the other party. To my knowledge there has never been a failure of mainstream CDS contracts to settle, even during the financial panic of late 2008.

I would be very surprised if US banks were carrying significant exposure to a Greek default. Betting on Greece is most likely limited to speculators and large institutional investors who have the wherewithal to suffer a loss. The risk of a default has been very high for quite some time, giving the market plenty of time to brace for it. Those with too much exposure to Greece have had the time and the opportunity to adjust their exposure to tolerable levels. Besides, a large bank would have to be borderline insane to want to take on significant Greek default risk in today's fear-ridden climate.

Benjamin Cole said...

The US Treasury seems to be able to borrow as much as it wants to. Yields going down. Treasury sales are oversubscribed,by a ratio of three.

If and ever the current financial scare session ends, I expect yields to fall even more, especially for high-yield bonds.

Japan has tried deficit spending and low interest rates (but not much QE) for 20 years, and it has not worked. They have chronic deflation, recession, and secular asset deflation.

I sure Japan is not our role model--we are choosing the same policies they did.

Bill said...


Thanks for the response. However, didn't the US have to bail out AIG because of the risk that it couldn't meet its CDS obligations in which case the entire financial system would have collapsed?

Scott Grannis said...

The issue you raise is quite controversial. I personally doubt that AIG's CDS exposure justified a bailout. I think the testimony of Joe Cassano is enlightening in that regard:

In the heat of the subprime fiasco, many risks were way overestimated. At the time there was great uncertainty and even panic, so it's not surprising that the risks were exaggerated. In retrospect, it appears to me that the AIG bailout was far from necessary.